King and Country: Reflections on the Costs of Market Misconduct

Read as updated SSRN paper with reference to the Panama Papers. Because of the Budget 2016, the chancellor has been accused of “looking more like Gordon Brown as a purveyor of gimmicks.” In difficult times when calls for his scalp over the row regarding the budget seemed to have eclipsed everything else, the rare bit of good news for George Osborne is that he can use the opportunity provided by the threat of Brexit – “a leap in the dark” which may cost the UK £100 billion or 5 per cent of GDP and 950,000 jobs by 2020 – to camouflage and obfuscate the real problems of conduct in the world of economics and finance. On the other hand, in an important interview with Charles Moore the former Bank of England governor Mervyn King showed hallmark signs of euroscepticism and said the people need to make up their own minds about the upcoming referendum. King also warned that lenders have not stopped taking excessive risks with savers’ money and the result is “bankers have not learnt the lessons of the Great Crash”. Unsurprisingly, in his somewhat controversial new book The End of Alchemy he makes the case against financial sorcery by arguing that it must be squeezed out of the world’s banking system. Perhaps, such failings are amplified further because “financial crises are a fact of life” and we are “moving into a rerun of the credit crunch”. Indeed, Lord King calls banks “the Achilles heel of capitalism.”

Below I sketch important/emerging issues in the intersecting themes of economics, law and misconduct as seen in the media, especially through the lens of “conduct costs” – some other themes are also explored. Mentioning Walter Bagehot and his classic text Lombard Street, which argued that the BoE should provide short-term financial support in times of crisis, King advises us that the old “lender of last resort” model (LOLR) is in need of revision because “banking has changed almost out of recognition since Bagehot’s time.” The former governor argues that the time has come to replace LOLR with the pawnbroker for all seasons (PFAS) system. For him, it is time for financial institutions to drop LOLR and embrace PFAS and be prepared to advance funds to just about anyone who has sufficient collateral. “The essential problem with the traditional LOLR,” argues King “is that in the presence of alchemy, the only way to provide sufficient liquidity in a crisis is to lend against bad collateral – at inadequate haircuts and low or zero penalty rates.”

LIBOR Roundup: Fraud, Misrepresentation and New Directions in Civil Proceedings

ICE Benchmark Administration, which took over LIBOR from the BBA in 2014, has published a roadmap for LIBOR and banks will no longer be able to manipulate the interbank rate once a new system comes into place this summer connecting the IBA’s computers to banks’ trading systems. “We built new systems to do the surveillance which run about 4m calculations every day, looking for collusion, or aberrant behaviour, or possible manipulation,” explained the IBA’s president Finbarr Hutcheson. He expressed confidence that traders will no longer be able to lie to improve their trading positions and said that anomalies would be investigated and reported to the FCA. The banks have paid billions in fines in relation to the benchmark’s manipulation. The Wheatley Review 2012 engineered and guided LIBOR’s transformation because the distorted benchmark, underpinning more than US$350 trillion in outstanding contracts, was “not fit for purpose”. But of course, the review’s author Martin Wheatley was ousted from office because of his overt aggressiveness, or his “shoot first” and “ask questions later” policy for bad banks. Under IBA oversight, daily LIBOR rates will be rooted in market transactions “to the greatest possible extent” by using a “waterfall” system devised to begin with transactions but relies on human input in circumstances when trading volumes decline.

IBA is extremely confident that the move will bring rectitude to the scandal ridden financial sector. Hutcheson said that coupled with the earlier changes, the roadmap will ultimately make LIBOR “one of the world’s most trusted, scrutinised and robust financial benchmarks.” Insofar as benchmark rigging from the old days is concerned, after the settlement (2014) in the series of reported judgments in the Graiseley Properties case, new claims have been brought and a series of fresh judgments were published in litigation arising out of disputes between the Property Alliance Group – a property developer with a portfolio worth about £200 million – and the Royal Bank of Scotland. RBS has been in the spotlight recently because of the fact that it has failed to generate profit for eight successive years and that its losses since the global financial crisis 2008 have exceeded £50 billion which is more than the £45 billion of taxpayers’ money used to bail out the ailing institution.

The Senior Managers Regime

Tom Hayes did not bring down a bank but he paid a heavy price for being a part of the wider dirty casino culture built into the world of finance. During his trial, important questions were thrown up about the degree to which his seniors were culpable in his actions. In applauding the Senior Managers Regime (SMR), which aims to fill the lacuna in the regulatory regime, it has already been argued that Sir Jeremy Cooke was right to say that those supervising Hayes were irrelevant to his crimes: they would, after all, raise the stale decades old “we didn’t know” defence. But this historical rebuttal has been stretched to its outer limits: too overworked and overloaded, it has crowded itself out. As Roger McCormick explained in a recent interview referring to the famous Swaps Case from the 1980s: “Patience has run out and it’s no longer acceptable for them to just say, ‘It’s not our fault, we didn’t know.’ Laws of this kind reflect that impatience. We’ve had enough of this. We can’t have big, unruly banks that are out of control with no one at the top really accepting responsibility for what’s going on.” We must not lose sight of the fact that a divergence of views exists in this field. Senior lawyers and academics do not necessarily see eye to eye on everything that the regulators say.

Some unknown authors in the media argue that: “The LIBOR conviction is welcome. Now directors must be held accountable too.” It is said that the trial “was a landmark moment in the cleanup of the City after the financial crisis.” Mark Carney pledged that the SMR will in principle apply to him and the Bank of England but the bank is uneasy about opening up to official auditors for fear that such proposals may reduce its autonomy. George Osborne has been, as of July, consulting in relation to a Bank of England Bill targeting accountability and transparency at Threadneedle Street. The bank is “uneasy” and “surprised” by thoughts of being swept within the audit powers of the National Audit Office outside whose scrutiny it has historically been. As regards future prospects of independence, the bank is not satisfied with the limited comfort offered by the retention of its policy making functions and potentially keeping them outside the scope of the National Audit Office’s oversight.

Hunter into Prey: City Watchdog Exposes its Achilles’ Heel – Part 2

The issues in the last post must be examined in light of the scandal which erupted in late 2014 when the FCA came under heavy fire from the Davis Report because of the highly irresponsible way in which it had leaked sensitive data to the media earlier in March that year. Simon Davis, a partner in the Magic Circle firm Clifford Chance, stressed that there had been nothing less than systemic failure. Davis was adamant that the FCA failed to address the issue of whether the information given out might be price sensitive. The conclusion was unsurprising because the leak culminated in an article in the Telegraph headlined Savers locked into ‘rip-off’ pensions and investments may be free to exit, regulators will say which claimed that the regulator was planning an investigation of 30 million pension policies, some sold as far back as the 1970s. Consequently, big insurance companies had billions wiped off their share prices. The misapprehension that selected annuity products would be picked out meant that major UK insurers saw their share prices plummet. The insurers called for Wheatley’s resignation. Even the Chancellor George Osborne bemoaned he was “profoundly concerned” by the episode. In his inquiry, Davis unearthed multiple failures symbolic of a dysfunctional organisation, and he emphasised that the regulator was “high-risk, poorly supervised and inadequately controlled.”

Davis – who was unsparing in his criticism – held the FCA’s Board responsible for the flaws in the regulator’s controls on the identification, control and release of price sensitive information. The buck ultimately stopped with the board because it “failed in its oversight of the FCA’s executive and … failed to identify the risks inherent in the FCA’s communications strategy.” The episode required urgent action and an external organisation needed to review the board’s practices and effectiveness. So serious were the mechanical failures of corporate governance of the City watchdog. To scotch the confusion, in light of public hearings that ensued, on 17 March 2015 the House of Commons Treasury Select Committee (the Treasury Committee) published Thirteenth Report (2014-2015): Press briefing of information in the Financial Conduct Authority’s 2014/15 Business Plan (HC881).

Changing Banking for Good: What is the Cure for Misconduct?

Not long ago, in the Changing banking for good (see Vol I and Vol II) report, the Parliamentary Commission on Banking Standards (PCBS), a body established in the wake of the LIBOR scandal, was horrified by shocking and widespread malpractice in the banking sector. It concluded that, in addition to bankers, governments and regulators have contributed to the degeneration of standards. The PCBS recommended wide-ranging changes relating to making senior bankers personally responsible and reforming bank governance by creating better functioning and more diverse markets. It also recommended reinforcing the powers of regulators to make sure that bankers do their job. Putting prolonged and blatant misconduct (which had been evident for a number of years) at the heart of the problem, the PCBS was of the view that its input would alleviate the industry’s woes – it said that the “challenge for government is to follow through on the commitment to far-reaching reform.” Update: an April 2016 sequel to this article dealing with the Panama Papers and Lord King’s new book The End of Alchemy (see my blogpost here) can be read on SSRN as Changing Banking for Good: Counting the Costs of Market Misconduct. In his book, Lord King calls banks “the Achilles heel of Capitalism.”

Almost two years on, unconvinced that the deficit of trust has been bridged, Dame Colette Bowe, of the Banking Standards Board (BSB) issued a general warning that the “banking industry must raise its game” because “trust in the system has been badly damaged and it’s no surprise that the public expects change after everything that has happened”. On the other hand, diminishing the weight of their own argument, they also offered a general concession

Transposing the BRRD

Directive 2014/59/EU, or the Bank Recovery and Resolution Directive (BRRD), aims to ensure that the European Union (EU) effectively addresses the risks posed by the banking system. The BRRD contains 133 Recitals and stretches 132 Articles and it aims to create a harmonised framework across Europe for dealing with the problem of “too big to fail” through bank recovery and resolution. It entered into force on 2 July 2014 and establishes a common approach within the EU to the recovery and resolution of banks and investment firms. Article 130 (Transposition) exacts that the Member States shall adopt and publish by 31 December 2014 the laws, regulations and administrative provisions necessary to comply with the BRRD and that the text of those measures shall be communicated to the Commission and, save Section 5 (The bail-in tool) of Chapter IV (Resolution tools) which has an implementation deadline of 1 January 2016, the said measures shall apply from 1 January 2015.

As recorded in the initial recitals, the BRRD is firmly embedded in the belief that the financial crisis was of systemic dimension in the sense that it affected the access to funding of a large proportion of credit institutions. Therefore, in order to avoid failure, with consequences for the overall economy, such a crisis necessitates measures aiming to secure access to funding under equivalent conditions for all credit institutions that are otherwise solvent.

Roger McCormick On Sustainable Banking

Workshop on the Financial Sustainability of Banks, Speaker: Professor Roger McCormick (London School of Economics) Chair: Professor Emilios Avgouleas (University of Edinburgh) held at UCL Faculty of Laws, Bentham House, Endsleigh Gardens, WC1H 0EG on Feb 6, 2013. 

A league table of Bad Banks might lead to improvements in the ethics of Banking, argued LSE’s Professor Roger McCormick at a UCL’s Centre for Ethics and Law event on Sustainable Banking. He drew on evidence to the Banking Standards Committee criticising the idea that what Banks needed were more lawyers and compliance staff. Doubting the efficacy of Codes of Conduct, he advocated a focus on steps that might genuinely influence banking conduct. If it is the case that codes and process measures can simply be worked round and recognising that basic values may be important it was necessary to find other techniques. Structures played a role: Professor McCormick pointed to the de-federalisation of Barclay as a positive sign that the Bank might be taking control of the compliance and ethics problems it faced, with reporting lines direct into the CEO.

But there was a profound need to realign the interests of boards who had often not been informed of illegalities and other problems in their Companies.

FSA’s Response to Fixing LIBOR

The Financial Services Authority’s Response to the Treasury Committee’s Second Report of Session 2012–13, Fixing LIBOR: some preliminary findings was published by the Committee on 21 February 2013. It is worth recalling that the Treasury Committee is appointed by the House of Commons to examine the expenditure, administration and policy of HM Treasury, HM Revenue & Customs, and associated public bodies, including the Bank of England and the Financial Services Authority (FSA). And, of course, the FSA’s response makes rather interesting reading (see below).

But prior to setting out the FSA’s responses, it is apposite to note the Committee’s Chairman Mr Andrew Tyrie MP (Conservative, Chichester) comments who said that:

• Our inquiry uncovered appalling behaviour and serious failings at many levels in Barclays; on the trading floors, on compliance desks and amongst senior management.

• It is now clear that these failures were not limited to a single institution. The systemic rigging of important rates appears to have been pervasive in the banking industry over a long period of time.

• Serious regulatory shortcomings also came to light. It is only right that the FSA has had to shoulder its share of the blame for this scandal.

The Libor Scandal and “Soft Law”

The ideal of sustainability is key to all modes of human activity and the financial sphere is no different. Following the onset of the global financial crisis, the governance of banks and business entities emerged as a burning issue. The Libor scandal has only served to intensify calls for greater accountability and transparency. Like HSBC, Barclays and UBS which have already been fined, see post here, the Royal Bank of Scotland (RBS) has jumped on to the whirligig and it has been fined £390m ($610m) by UK and US regulators for its part in the Libor rate-fixing scandal. The Financial Services Authority has fined RBS £87.5m and £300m shall be paid to US regulators and the US Department of Justice.

A large body of opinion, myself included, advocates using criminal law punishments to bring about change and force banks and businesses to behave and become better citizens in the financial world. Key academics – like Professor Bainbridge and Barry Turner – have endorsed my views. However, on proper analysis, perhaps it was I who had unknowingly subscribed to such well-established positions. Yet, equally weighty reasons exist why “soft law” options may present more advantageous alternatives to solving the problems in the financial sphere. Last month, acclaimed lawyer and academic Professor Roger McCormick – author of the celebrated banking textbook Legal Risk in the Financial Markets and Director of the LSE’s Sustainable Finance Project – took the time explain to me why options other than criminal punishments needed exploration to tame the crises emerging in the financial world. And I remain extremely grateful to him.

Banking Reform: Ring-Fence Needs Electrification Says Commission

The Parliamentary Commission on Banking Standards (“the Commission”) published its first report on 21 December 2012. I would like to thank Michael Jacobs of Herbert Smith for bringing it to my attention via his Linkedin comment. Moreover, I would also like to thank Professor Bainbridge for encouraging me to delve deeper into the idea that the Libor problem is best analysed through the lens of enterprise liability versus agents’ civil and criminal liability. Quite rightly, the Professor prefers the latter deterrent. Why should shareholders and other innocents pay for the inadequacies of governance in the corporate sphere? Surely, instead, the bankers and traders who fixed and manipulated Libor should be criminally punished.

Although regulators were aware of Libor being manipulated as early as 2007 ( for example in 2008, Mervyn King himself told Parliament that Libor “is in many ways the rate at which banks do not lend to each other, … it is not a rate at which anyone is actually borrowing”), no action was taken to punish wrongdoing until this year. And when something was finally done, rather than the real culprits being held accountable, massive fines were imposed. Inevitably, shareholders were punished and equity was destroyed. Not a great solution by any stretch of the imagination.